Why make good borrowers pay for bad ones?

It's unfair, isn't it? That good borrowers are not rewarded for their discipline and are forced to subsidise indisciplined borrowers who may pose higher credit risk, says Harshala Chandorkar, Senior Vice President, Consumer Services & Communication, CIBIL.

Kunal Sharma, 35, is a lecturer in a government engineering college who wants to avail a home loan. He wants to purchase a flat for his family. He has been diligently paying the equated monthly installments (EMIs) on a car loan availed five years ago and has a good credit history. His has a credit score of 835 thanks to the financial discipline cultivated over the years.

Anil Gupta, a salaried employee with an MNC owns two credit cards and has availed an auto loan as well as a personal loan. Anil has been careless while managing his finances. While he has never defaulted, he has often delayed payment of credit card bills and personal loan EMIs. Anil 's credit history reflects delinquent credit behaviour and this has negatively impacted his credit score, which hovers around 708. Anil, too, now plans to avail a home loan for purchasing a plush apartment in an elite locality.

Yet, when they approach a bank, both Kunal and Anil are likely to get a loan at the same rate of interest and similar terms and conditions. Kunal's credit score won't quite help him get a better rate than Anil.

It's unfair, isn't it? That good borrowers are not rewarded for their discipline and are forced to subsidise indisciplined borrowers who may pose higher credit risk...

An equitable system that rewards good borrowers for their discipline and penalises delinquent consumers and discourages habitual defaults is the need of the hour.

To this end, the case for risk-based pricing of loans cannot be understated.

The Reserve Bank of India is driving efforts towards promoting fair lending practices and has directed banks and credit institutions to ensure transparent, realistic and risk-based pricing of loan products for borrowers.

Risk-based pricing reflects a practice used by lenders to set credit terms, such as interest rate or credit limit, according to a consumer's credit risk, as reflected by her/his credit behaviour in credit reports. Lenders that employ risk-based pricing generally offer more favourable terms to consumers with credit histories that reflect lower risk and less favourable terms to those whose credit histories reflect higher risk.

Several World Bank reports and case studies have shown that a risk-based pricing environment based on credit information data improves loan performance by reducing delinquency rates and containing non-performing assets. Credit penetration is achieved by significantly identifying “good borrowers” (low credit risk) that otherwise would have been misidentified as “bad borrowers” (high credit risks) and therefore, may not have been provided credit at optimal terms and conditions. At the same time, high-risk borrowers are no longer subsidised by lower-risk consumers.

In turn, this risk-based pricing environment drives customer loyalty while improving transparency and soundness in the lending process. Borrowers like Kunal Sharma who have a better credit history are rewarded for their discipline, while less disciplined borrowers like Anil Gupta are not. In the aggregate, lending increases, leading to greater economic growth, productivity and even financial inclusion.

With the developments in the credit sector in India and evolution of credit bureau infrastructure, we shall soon experience a risk-based pricing environment in our country. Borrowers with a good credit history may be able to bargain and avail better terms and conditions and lower interest rates on loans and credit cards. 

Illustration: Uttam Ghosh/Rediff.com